China frees up lending rates in major reform

China’s central bank removed controls on bank lending rates, effective yesterday, in a long-awaited move that signals the new leadership’s determination to carry out market-oriented reforms.

The move gives commercial banks the freedom to compete for borrowers, a reform which the People’s Bank of China said on Friday would help lower financial costs for companies. Previously, the lending floor was 70 percent of the benchmark lending rate.

However, the People’s Bank of China, in a statement, left a ceiling on deposit rates unchanged at 110 percent of benchmark rates, avoiding for now what many economists see as the most important step Beijing needs to take to free up interest rates.

The latest step underscores Beijing’s resolve to start fixing distortions in its financial system and the economy more broadly as it tries to shift from export-and investment-led growth to more consumption-led activity.

Some analysts said cheaper credit could help support the economy, which has seen year-on-year growth fall in nine of the past 10 quarters.

“This is a big breakthrough in financial reforms,” said Wang Jun (王軍), senior economist at the China Center for International Economic Exchanges (中國國際經濟交流中心), a prominent government think tank in Beijing. “Previously, people had thought the central bank would only gradually lower the floor on lending rates. Now they scrapped the floor once and for all.”

The announcement provided some support to weak stock markets in Europe and a timely reminder to the world’s top financial leaders meeting in Moscow of China’s intention to rebalance its economy.

A G20 draft communique would urge China to encourage more domestic demand-driven growth as part of wider efforts to rebalance the world economy, G20 sources said.

The US welcomed the move, saying China promised to let markets play a bigger role in allocating credit during the US-China Strategic and Economic Dialogue in Washington.

China’s big lenders, such as the Industrial and Commercial Bank of China Ltd (中國工商銀行), China Construction Bank Corp (中國建設銀行), Bank of China Ltd (中國銀行) and Agricultural Bank of China Ltd (中國農業銀行), have generally resisted interest rate reforms because they do not want to see their rate margins get squeezed.

However, many economists say such a push is necessary so that lenders learn to better price risk, which will force them to allocate capital more efficiently and so help rebalance an economy saddled with overinvestment and overcapacity in sectors from cement to steel making to solar panels.

Scrapping the lending floor will likely cut borrowing costs for businesses and individuals, ending what many observers say had been artificially high rates that benefited state lenders at the expense of private enterprise.

Some economists were skeptical at how much direct economic impact the move would have because few banks have fully utilized the limited freedom they already had to charge interest rates slightly below benchmark rates, choosing instead to keep their rates slightly above the floor that has been in place.

“So the move may have more of a signaling effect than transmit immediately to the economy, but it is an important signaling effect,” said Manik Narain, emerging market strategist at UBS in London.

However, to the extent that it does lead banks to lower their lending rates, the move could serve to stimulate investment at a time when the world’s second-largest economy is running around its lowest growth rates since 2009, having logged 7.5 percent growth in the second quarter.